New money for chip equipment makers?

MattAndrejczak

SAN FRANCISCO (MarketWatch) -- When Lam Research Corp. CEO Steve Newberry heads to New York or Boston to talk with prospective investors, he's noticed that value-oriented fund managers are now showing up to size up the chip equipment industry.

That didn't happen before.

"The industry has changed," remarks Newberry, alluding to a much shorter timeframe to fill orders, fewer buyers of semiconductor manufacturing machines and less-rambunctious spending sprees by chipmakers.

Investors have already been jumping into the sector, pushing the shares of companies such as Applied Materials and KLA-Tencor up more than 45% over the last 12 months.

Lam has surged even more, having watched its share price nearly double in that time to reach record-high territory over the last couple of weeks.

A common mantra today is "muted cycles." That is, when execs speak about order flows, they expect less of a high in good times and less of a low in bad times. In other words, the industry is riding a new rollercoaster, one whose tracks are shorter and not so steep.

So, should investors modify their strategy?

Traditionally, chip-equipment stocks have marched to the drumbeat of order-book flows and capital spending plans by electronics makers, with investors scouring the market for any datapoints about the next possible upturn or downturn in technology spending.

It's typically worked this way: Information suggesting equipment orders would rise was a sign to pump money into the whole sector, regardless of individual company fundamentals. Conversely, data suggesting orders would slow was a sign to bail.

"Ten years ago, these companies made great money during the booms, but when we went into downcycles, these companies lost a ton of money," said Patrick Ho, analyst at Stifel Nicolaus. "If you look at these companies today, many have changed their business models."

In investment circles, Lam Research Corp.
LRCX, -3.08%
and Varian Semiconductor
VSEA
are often cited as two prime examples. Also mentioned, but to a lesser extent, is sector leader Applied Materials Inc.
AMAT, -1.62%
and KLA-Tencor Corp.
KLAC, -2.32%

These companies are now more prepared to absorb the shock that comes when tech spending skids off the tracks, analysts note.

Chip equipment makers have accomplished this by either outsourcing manufacturing to chop expenses, using new tools to win share in existing markets or restructuring service warranty tool contracts to make more money. And in some cases, they have chosen to enter new markets outside the semiconductor space, such as solar energy.

Looking for market share

When doing his research, Summers isn't entirely focused on the potential direction of the equipment spending curve. He's trying to identify chip-equipment suppliers who stand to benefit from outsourcing, an emerging trend taking hold in the industry.

In Brooks' case, the company makes the robotic-like arms that move chip wafers around the inside of semiconductor machine and holds vast intellectual property for those designs.

Applied and Tokyo Electron Ltd., the world's two largest chip-gear providers, also make robotic arms but Applied has shifted some that business to Brooks. Tokyo Electron plans to take the same approach but hasn't announced who will be the beneficiary, Summers said.

His thinking is Brooks, whose stock has gained 18% so far this year.

In regards to Ultra Clean, which assembles and tests equipment, chip machine makers want more of their equipment installed in Asia, where most of their customers are. This helps cut costs and deliver equipment faster.

Ultra Clean, based in Menlo Park, Calif., wants to take advantage of that trend with a facility it opened in Shanghai, China in late 2004, Summers said. Its stock is up 14% this year.

Benefits of outsourcing

The outsourcing movement circles back to Lam, the world's No. 5 chip-equipment maker based in Fremont, Calif. whose stock has surged 150% the past year years.

It uses Ultra Clean to assemble its equipment as part of a broader outsourcing model that uses outside firms to perform human resource functions, information technology, and facilities management.

Lam is considered an industry pioneer in this respect. The goal is being able to stay profitable through spending slumps and to be even more profitable during spending booms.

Industrywide, "this is not a trend that will go on for a few quarters and die out. This is a trend that will take years to play out," Summers added.

Lam's moves have made it an investor favorite. Its shares have soared 140% since August 2004. By comparison, rivals Applied and KLA-Tencor have gained around 40%.

The inevitable cycles

When it comes to investing in chip equipment stocks, there is no avoiding the cycles. The cycles will never vanish. Equipment providers cannot fill orders overnight. But investors are looking beyond the cycles and the psychology is evolving, said Stifel's Ho.

He now fields calls from clients asking who the best companies will be three years from now.

"I didn't used to hear that question. That's clearly a different mindset than five years ago," Ho said.

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